Buy Index Funds: How to Buy Index Funds in 7 Steps (+ Detailed Guide)

How to buy index funds
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Index funds buy stock baskets to track the performance of market indices such as the S&P 500. As a result of their low cost and ease of diversification, index funds have become a staple of investment and retirement portfolios. In this post, we will get you started on how to buy index funds to help you achieve your retirement and investment objectives.

How to Buy Index Funds

Buying index funds is a simple procedure—all you need to know is what you’re looking for.

#1. Decide Where To Buy

Deciding where to buy your index fund is the most crucial step in this process. It may be the determining factor to how successful you would be in this line of business.

For starters, you can purchase directly from a mutual fund or a brokerage firm. We’ll propose a few good places to look at in a different post. In the meantime, here are a few things to think about while selecting a provider:

Selection:

Each supplier will have a distinct range of funds to offer. The biggest mutual fund companies frequently sell both personal index funds and those of their competitors. A broker, on the other hand, might offer funds with a wider range of equities. Your best bet, however, is to look around for a service that offers what you’re looking for.

Ease of Use:

If you’re solely looking to buy index funds, a mutual fund business may be a better option. However, if you want to invest in index funds as well as other instruments such as stocks and bonds, you might want to use a broker. A broker can help you with a variety of investments, and you’ll have less paperwork come tax season.

Transaction Fees:

Some service providers waive transaction fees, while others do not. Mutual fund companies typically charge a $20 or more commission. Consider your budget as well as the index fund’s overall profitability.

Read Also: Best Index Funds: Top 13+ 2021 Picks for Beginners and Pros

#2. Open an account with a brokerage firm.

To buy index funds, you’ll need an investment account. Various types of investment accounts are best suited for various objectives:

Mid- and Long-Term Goals

Taxable investment accounts allow you to create wealth by investing, but also compel you to pay taxes on dividends and profit from investment sales. Taxable accounts are beneficial to those who want to accomplish major financial goals before retirement or who have already reached their annual retirement account limits.

Retirement

Traditional IRAs and Roth IRAs, for example, provide tax advantages that can help you save for retirement. If you try to make withdrawals before you turn 59 and a half, you’ll almost certainly owe a 10% penalty as well as taxes on any money that hasn’t been taxed yet.

Expenses for education

529 accounts are a good option for parents who want to aid their children with educational costs. These accounts have tax advantages comparable to retirement accounts in that you may be able to deduct contributions and investments grow tax-free while in the account. Furthermore, any withdrawals utilized for approved education expenses, which now cover both high school and college tuition as well as broader educational costs linked with further education and trade schools, will be tax-free.

Children

Custodial accounts (also known as UTMA/UGMA accounts) allow you to invest on behalf of a minor. The funds in the account can be utilized for a child’s benefit and become totally theirs when they reach a legally defined age, usually 18 to 25, depending on the state in which the account is held.

You buy and sell your own investments using an online brokerage account, and costs are usually low. If you choose a managed brokerage account with a human investment advisor, you’ll often pay a proportion of your assets every year to have someone manage your investments for you, such as 1%.

A robo advisor account is also an option. An algorithm will recommend a portfolio mix for you once you answer a few questions about your risk tolerance, time frame, and goals. This is convenient, but you’ll pay more than you would if you did it yourself. Wealthfront and Betterment, for example, take 0.25 percent of your assets each year as a fee. (An account with $10,000 in it would cost $25 per year in fees.)

Read Also: Active Investing vs. Passive: Understanding Why You Need Both (+Detailed Guide)

#3. Make a decision on how you want to invest in index funds.

Your overall financial goals, risk tolerance, and timescale are all factors in your index fund investment plan. If you engage with a financial advisor, they can assist you in determining the optimum fund mix for your needs. On the other hand, If you open an account with a robo-advisor, the algorithm will recommend a strategy based on your responses to the account’s questions.

But in any scenario where you decide on an index fund allocation on your own, an online tool can help point you in the right direction. Vanguard, for example, uses an online questionnaire to recommend an index fund asset mix based on your timeline, risk tolerance, and investing preferences. You can also use Fidelity’s investment tools without having to open an account, such as the ability to create an investment strategy.

When you’re closer to a goal, advisors recommend keeping more of your portfolio in stocks and less in fixed-income products like bonds. As you move closer to your goal, gradually shift your asset allocation away from stocks and toward bonds.

The amount of risk you’re willing to accept determines how aggressive you are, which is represented in the ratio of stock index funds to bond index funds. Basically, for goals that are less than three years away, high-yield savings accounts or certificates of deposit may be a better option. Consider taking on additional risk by investing in stock index funds for longer-term goals that are more than three to five years away.

What’s next?

#4. Pick your index funds after doing some research

It’s critical to understand what you’re getting from an index fund, so do your homework.

First, choose an index—or several indexes. The S&P 500 is the most well-known index. Although there are also indexes based on firm size, industry, and market opportunity, such as emerging markets. Equity indexes are a good way to add growth potential (and risk) to your portfolio. Basically, the more niche your equity index is, the more risk you’re taking on.

Bond-based indices give investment portfolios better stability and lower returns.

Start your search with the following indexes:

  • The Dow Jones Industrial Average, S&P 500 Index, NASDAQ, and Wilshire 5000 Index are all broad market indexes. Those wishing to build basic two- or three-fund portfolios frequently choose funds that mirror one of these fundamental indexes.
  • The Russell 3000 Index (large-cap companies), Russell 2000 Index (small-cap companies), and S&P 400 Index are all equity indexes that group companies by size (mid-cap companies). In general, the smaller the companies in an index, the greater the risk and opportunity for growth.
  • MSCI Indexes, for example, provide exposure to stocks from companies based outside of the United States. The less developed a country’s economy is, the greater the risk and opportunity for growth.
  • The Barclays Capital Aggregate Bond Index, for example, is based on the bond and fixed income markets. Corporate bond indexes often provide larger returns (but also more risk) than government bond indexes.

After you’ve decided on an index or indexes to buy, you may start looking at particular funds. Here are some factors to think about while comparing index funds:

Expense Ratio

This is the annual cost of administering the fund. When all other factors are equal, index funds that track the same index will all track the same thing, therefore the expense ratio can be a key deciding factor. If one fund charged 0.19 percent and another 0.03 percent, choosing the lower-cost fund would save you $16 per $10,000 invested each year.

Other Charges

Most big brokerages don’t impose trading fees on index funds but keep an eye out for loads or extra costs levied by some mutual funds when you buy or sell them. Most large brokerages should be able to find index funds for any index without excessive or unnecessary fees. So don’t choose a fund with loads just because it’s the first you’ve found.

Minimum investment requirements

You can cross that fund off your list if you don’t have enough money to meet the minimum investment requirement.

If you really want to invest in that index, look for the exchange-traded fund (ETF) version, which typically has no minimum investment beyond the price of one share.
Remember that index funds tracking the same index at different companies will have nearly identical holdings, so keep expenses in mind.

“In reality, if you pick an index like the S&P 500 and ask, ‘Do I want Vanguard, Fidelity, or Schwab,’ they’re all essentially the same,” says Ron Guay, a certified financial planner in Sunnyvale, Calif.

“You’re buying the identical content; the only difference is the wrapping or brand.” Expense ratios, trading fees, and loads are all things to keep in mind. To save money on fees, you’ll generally want to invest in index funds offered by your brokerage.”

#5. Buy the Index Funds

You can now buy shares of the index funds you’ve chosen once are done with your research and may have opened a brokerage account. In most cases, you’ll have to look for or type in the fund’s ticker symbol as well as the monetary amount you want to invest.

You’ll also need to purchase enough shares to meet the fund’s investment minimum. After this, most accounts give you the luxury of buying fractional shares in the future. The platform may also inquire about your dividend preferences, such as whether you want your dividends utilized to buy more fund shares or go into your account as cash.

However, most experts recommend reinvesting dividends if you’re a long-term investor. This is because dividends traditionally provide significant investment gains.

#6. Create a Buying Strategy for your Index Fund Investments

Eventually you’ll need to consider your strategy for buying index funds over time. This is because investing is often long-term.

“The beauty of dollar cost averaging is that it allows investors to add to their portfolio in both high and low markets, removing the emotional pressure to purchase high and sell low,” says Erika Safran, a New York City-based financial planner.

Dollar-cost averaging is the process of investing a specific amount of money at regular intervals, as recommended by financial consultants.

Set up automated investments with your brokerage on a regular basis (such as once a month or every payday) to do this. This ensures that you’ll keep investing on a regular basis.

In general, investing is about the long game. While the stock market has its ups and downs, buying and holding a varied investment mix throughout the course of your investing career has traditionally resulted in favorable returns.

So review your portfolio every six to twelve months for outcomes, and rebalance when your investments have strayed too far from your original goal. You can sell some of the divisions that have grown too large and buy more of the divisions that have grown too little to rebalance. This keeps your portfolio on track to meet your objectives.

#7. Make a decision about your exit strategy.

While buying and holding is a good investment strategy, you should also consider when and how you’ll sell your stock. If you’re investing in a taxable account, you’ll need to think about capital gains taxes and whether you can offset those gains with losses from other investments through a process known as tax-loss harvesting. If you have a tax-advantaged retirement account, think about how you can reduce the amount of taxable income you earn each year by withdrawing money from it.

A financial advisor or tax professional can assist you in determining the best withdrawal strategies for any type of investment account.

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